1. Balance-Sheet Liquidity and Approaches to Its Stress Testing

2. Liquidity (Nikolaou, WP No 1008, 2008, ECB)
Liquidity in terms of flows: flows among the central bank, commercial banks and markets.
Liquidity in terms of ability: ability realising these flows.
Central bank liquidity (CBL): the ability of the CB to supply the liquidity needed to the financial system (ECB)  CBL risk is non-existent.
Funding liquidity (FL): the ability of banks to meet their liabilities, unwind or settle their positions as they come due (BIS)  FL risk is the inability to service their liabilities as they fall due.
Market liquidity (ML): the ability to trade an asset at short notice, at low cost and with little impact on its price  ML risk is the inability of trading at a fair price with immediacy. 2

3. Liquidity linkages (Nikolaou, WP No 1008, 2008, ECB)
Each liquidity type depends on the good functioning of the other two types.
A virtuous liquidity circle in normal periods: CB provides the amount of liquidity, markets ensure its re-distribution and recycling and funding needs its efficient allocation among the agents. That fosters financial stability.
A vicious illiquidity spiral in turbulent times: the strong linkages remain but they rather serve as risk propagation channels and destabilise the financial system.
Provision of liquidity
(Re)distribution and recycling
Efficient allocation of resources 3

4. Example: The crisis hit the Czech financial markets too
The market liquidity has rapidly fallen ….
The CNB introduced liquidity-providing repo operations aimed at fostering the functioning of the government bond and money market.

5. Despite the existing favorable position we test banks for liquidity-associated risks
Main objective: to investigate liquidity risk not only as a source of bank funding risk (the ability to raise cash to fund assets), but also as strong link to market liquidity (the ability to convert assets into cash at a given price).

6. … a simple illustration of the lack of liquidity ...
Promises from the past
LIQUIDITY SHORTFALL
Uncertainty about the future =
Assets = usage of funds
Liabilities = funds
A bank must solve:
A bank promised to lend (credit lines)
but
may not have enough funding sources
(even more impaired financial markets, withdrawals)

7. Banks` liquidity buffer vs. stressed cash outflows
Banks normally have liquidity reserves consisting of liquid securities or cash to cope with unexpected cash outflows.
Unexpected cash outflows (some examples):
Loss of confidence in a bank,
Frozen money markets,
Withdrawals of deposits, or/and
Drawdowns of credit lines.
The question is: Are banks` liquidity reserves sufficient and liquid enough?

8. (1) A liquidity buffer is ample and liquid enough
The difference between funding (liabilities) and illiquid assets (the blue rectangle) is the funds invested in liquid assets (the red rectangle).
Liquidity tension: (a) impossible banks‘ securities issuance, (b) withdrawals from private individuals and (c) higher credit facilities usage.
A bank with a larger liquidity reserves, a larger proportion of deposits and a smaller proportion of securities that will mature over shorter notice…
…survives and its liquidity buffer is ample and liquid enough.

9. (2) The liquidity buffer is not sufficiently ample and liquid
The difference between funding (liabilities) and illiquid assets (the blue rectangle) is the funds invested in liquid assets (the red rectangle).
Liquidity tension: (a) impossible banks‘ securities issuance, (b) withdrawals from private individuals and (c) higher credit facilities usage.
A bank with a smaller proportion of deposits and higher dependence on market funding (a large proportion of securities that will mature over shorter notice)…
… fully exhausts its liquidity reserves.

10. The current LST for the Czech banking system examine…
Top-down approach originally developed by De Nederlandsche Bank with some CNB`s modifications.
The 3-Phase Test captures the impact of both bank-specific and market wide scenarios and considers both the first- and second-round effects of shocks with a survival period of one month.
1st phase (first-round effects): two dimensions:
(a) a liquidity shortfall,
(b) drying up of market liquidity,
2nd phase: reactions by banks to mitigate shocks and restore LB,
3rd phase: negative reputational impacts and collective behavior (second-round effects) – the feedback effects of shocks – some additional impact on LB.
pressures on the initial liquidity buffer (LB)

11. … whether Czech banks are being able to survive arisen liquidity tension.
1st
2nd
3rd

12. Initial liquidity buffer
Starting point - liquidity buffer (LB0) as the first line of defense
LIQUID ASSETS (LB) 1.
CASH 2.
CLAIMS on CEBs 3.
CLAIMS on other clients (non-financial, financial) on demand and due within 1 month 4.
BONDS (bills) issued by government 5.
BONDS (bills) issued by CEBs
Liquidity buffer (LB):
Banks` holdings of liquid assets in case of unexpected tensions in its balance-sheet;
Definition: sum of unweighted liquid assets (initial level of banking system assets under normal conditions).

13. Scenario ==> 1st round effect ==> LIQUIDITY SHORTFALL, ↓ LB
Scenarios‘ impact
Scenario ==> 1st round effect ==> LIQUIDITY SHORTFALL, ↓ LB
1st round of shocks:
first three items above are affected at once;
two premises are linked to credit and market shocks.
Liquidity shortfall: difference between the amount of the aftershock assets and liabilities;
Banks` reaction: sales of assets under restrictive conditions.

14. Dependence on macro stress testing
LST takes into account the results of the credit and market risk stress testing:
The higher losses the greater outflow of liquidity,
The less quality the higher haircuts.

15. Mitigate the impact of shocks
LIQUIDITY SHORTFALL ==> Reactions by banks ==> Mitigate 1st round effects ==> ↓Liquidity buffer (LB1)
Reaction: banks can reduce assets only due to constrains on funding (the liability side can not be increased):
banks first liquidate the initial liquidity buffer (the most liquid assets) reflecting market liquidity, their specialization and their strength of presence in financial markets – cash, claims on CEBs, sovereign bonds…),
and then the other items (run out of liquidity buffer) – high haircuts.

16. … a simple illustration of banks‘ reactions...
Market dilemma:
Reputation risk: …Why is that bank selling?  Stigma
(b) Systemic risk: …too many banks are selling, the same assets…
Selling more for lower price
Assets
PRICE DECLINE
NO PRICE

17. Impact of the 2nd round of shocks
Reactions by banks ==> Loss of reputation and collective behavior ==> 2nd round effects (feedback) ==> ↓Liquidity buffer (LB3 )
The behavioural reactions have wider disturbing effects on markets and feeding back on the banks  additional haircuts on assets and withdrawals of liabilities. The feedback effect is stronger for reacting banks.
Loss of reputation: signalling effect;
Systemic risk (collective reaction) depends on:
(i) the number of reacting banks,
(ii) the similarity of the banks‘ reaction, and
(iii) the size of reacting banks;
Market conditions: reaction on liquid and developed versus illiquid and shallow markets.

18. Scenarios CNB‘s FSR 2010/2011 (data at the end of 2010)
The same scenarios as for macro stress testing (Asymmetric Developments, Renewed Recession).
The Renewed Recession scenario would cause liquidity problems, but these would not be systemic in nature.

19. Results CNB‘s FSR 2010/2011 (data at the end of 2010)
The tested banks withstood the simulated stress and would be able to close the potential liquidity gap within one month even under worsened market conditions.
Only a few banks would fully exhaust their liquidity buffers by their response to the liquidity shock.

20. Zátěžové testy likvidity 2012 dopadly rovněž uspokojivě
Metodologie shodná jako v 2011 (dvě kola šoků, šoky navázány na výsledky bank v testech solvence), nově však provedeny separátně pro jednoměsíční a tříměsíční horizont.
Likviditní polštář by se v průměru snížil o dvě třetiny, v segmentu stavebních spořitelen by v případě tříměsíčního horizontu klesl o více než 80 %.
Jedna banka (v případě 3M horizontu dvě banky) by zcela vyčerpala likviditní polštář.

21. Výsledky makrozátěžových testů likvidity bank I - 2015
Banky prokázaly vysokou odolnost vůči likviditním šokům.
Likvidní polštář úrovně 1 vyčerpala pouze 1 banka pro 1měsíční horizont a 8 bank pro 3měsíční horizont; polštářem úrovně 2 by pak nepokryly odliv pouze 3 banky pro 3měsíční horizont. 26

22. Výsledky makrozátěžových testů likvidity bank II - 2015
Metodika zátěžových testů likvidity byla rozšířena s ohledem na nový regulatorní rámec (LCR).
Individuální pozice bank měřené LCR jsou v souladu s výsledky testů likvidity.
Odhad LCR dosahuje agregátní hodnoty 192 %.
Regulatorní limit LCR ve výši 60 %, platný od října 2015, by nesplnila jen 1 banka.
Negativní charakteristikou likvidity sektoru zůstává nízká diverzifikace likvidní rezervy (převažují české SD). 27

23. Main formulas: An initial liquidity buffer: A liquidity shortfall:
…for potential uses
Main formulas:
An initial liquidity buffer:
A liquidity shortfall:
An available liquidity buffer:
Banks` reactions:
For non-reacting banks
The second round of shocks:
Haircuts:
For reacting banks

24. Relevant literature
Van Den End, J. W. (2008): Liquidity Stress-Tester: A macro model for stress-testing banks‘ liquidity risk, Dutch National Bank, WP No. 175 (May).
IMF (2011): Global Financial Stability Report, Chapters 2 – Liquidity Risk: How to Address the “Systemic” Part (March).
Barnhill, T., Schumacher, L. (forthcoming): Modeling Correlated Systemic Liquidity and Solvency Risks in a Volatile Environment with Incomplete Information, IMF WP.
Wong, e., Hui, C.H. (2009): A Liquidity Risk Stress-Testing Framework with Interaction between Market and Crecit Risks, Hong Kong Monetary Authority, WP 06/2009 (March).
Aikmen, D., Piergiorgio, A., Eklund, B., Gai, P., Kapadia, S., Martin, E., Mora, N., Sterne G., Willison, M. (2009): Funding Liquidity Risk in a Quantitative Model of Systemic Stability, Bank of England, WP No. 372 (June).
Riskbank (2010): Financial Stability Report, 2/2010.
Van Den End, J. W. (2010): Liquidity Stress-Tester: Do Basel III and Unconventional MP Work?, Dutch National Bank, WP No. 269 (December). …
Adrian, T., Shin, H. S. (2009): Money, Liquidity, and MP, FED of NY, Staff Reports No. 360 (January).
Cifuentes, R., Shin, H. s., Ferrucci, G. (2005): Liquidity Risk and contagion, Journal of the European economic association, (April-May).
Brunnermeier, M., Pedersen, L. H. (2009): Market Liquidity and Funding Liquidity, Review of Financial Studies, 22(6), p
Praet, P., Herzberg, V. (2008): Market liquidity and banking liquidity: linkages, vulnerabilities and the role of disclosure, FSR – Special issue on liquidity, Banque de France, No. 11.
Adrian, T., Shin, H. S. (2008): Liquidity and financial contagion, FSR – Special issue on liquidity, Banque de France, No. 11.
Nikolaou, K. (2009): Liquidity (risk) concepts: definitions and interactions, ECB WP No (Feb.).